Big Tax Court Win for Small Businesses and R&D Tax Credit

(alliantgroup; Published October 2014)

At a time when our country needs to encourage entrepreneurs and innovative small businesses, the tax court in a recent decision (Suder v. IRS – T.C. Memo 2014-201) sent a positive signal that small businesses can and should look to tax savings from the R&D tax credit. There are a number of important lessons from this case that are both good news for business owners and a setback for efforts to create a class of “routine research” or “routine engineering” that isn’t eligible for the R&D tax credit.

We are pleased to note that the taxpayer was represented by three of alliantgroup’s top attorneys – Jeremy Fingeret, John Dies and Robert Wonish. Additionally, based on ESI’s use of alliantgroup’s methodology to claim the credit, the court sustained 91.67% of the claimed research (11 of 12 projects) and tossed all efforts by the IRS to impose penalties on the taxpayer, citing in detail (Memo at p. 24) the company’s reliance on the alliantgroup methodology in claiming the R&D tax credit for the years 2004-2007.

The Suder case involves the classic American success story. Mr. Suder founded a company in 1987, Estech Systems, Inc. (ESI) to develop various products, including hardware and software, in the telecommunications industry. At first, Mr. Suder was a chief cook and bottle washer, but later developed and designed the innovations of ESI. ESI hired its first employee in 1988 and by 2004 ESI had grown to 125 employees – including 40 engineers – and revenues of $38.5 million. Throughout, Mr. Suder (typical of a founder/innovator – see Steve Jobs) continued to be actively involved in ESI as a fount of new ideas and designs.

Over a three week trial the court heard extensive testimonial and documentary evidence and determined that of the 12 projects reviewed, 11 met the four-part test required of the R&D tax credit – 1) expenditures connected with the research must be eligible to treated as expenses under section 174; 2) the research must be undertaken for the purpose of discovering technological information; 3) information to be discovered be useful in the development of a new or improved business component of the taxpayer; and, 4) substantially all of the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability or quality. Further, based upon alliantgroup methodology, the court found that the projects and allocations of time for all employees had been properly substantiated to claim the R&D tax credit.

The IRS argument held on to the feather of its expert witness – and crashed to earth. The court found that the IRS expert had “no factual basis in his report” for the assertions made against ESI (Memo at p. 40). The court then found that: “Many statements in [the IRS expert’s] report are contradicted by credible evidence in the record.” (Memo at p. 41)

More importantly, the Suder decision should be read that for businesses that are often building on the work of others and applied research that they may be eligible for the R&D tax credit. The court emphasizes that there is not a requirement under the R&D tax credit to “reinvent the wheel.” (Memo at p. 48). The court recognized the reality that so much of the work of industry is application of known engineering principles to components and that these components “. . . do not function in isolation. They interact with each other and with many other components, such as resistors, capacitors, and transistors, on a circuit board. Determining the appropriate configuration of the components involved a considerable research effort.” (Memo at p. 49). Also key is that the court recognized the research involved in developing new software that was either layered on top of newly developed hardware or added features or functionality to existing systems. (Memo at p. 51). In short – the court understood the real world of businesses and innovation.

As a leader in helping small and medium businesses qualify for the R&D tax credit, we see scores of IRS examinations. The Suder decision ends the efforts to push forward in examination a concept of “routine research” or “routine engineering” as being outside the R&D tax credit, ignoring the reality of incremental changes and modifications being the heart and soul of innovation performed by companies in the real world and economic growth in this country. The tax court in Suder has put a stake in that argument.

The other issue relevant to other business owners from the Suder decision is whether Mr. Suder’s wages could be included as qualified research expenditures. Some at the IRS have had difficulty getting their minds wrapped around the idea that a CEO can also be an innovator (which is actually the most common reality for many small and medium businesses – the top guy is the top innovator). The court found Mr. Suder (and others) as credible witnesses on the issue that he played a major role in the product development at ESI and that his 75% allocation was substantiated.

The ding on the taxpayer in Suder was that in looking at the overall compensation of Suder, the court found that the pay did not meet the reasonableness test. The court did agree with the taxpayer’s expert on reasonable compensation (finding that Mr. Suder’s base compensation, bonus and long term incentive was reasonable as claimed) and, most importantly, with the taxpayer’s allocation of 75% of Mr. Suder’s wages towards qualified research expenditures (and 25% on nonqualified service). However, the court did not consider the “royalty component” of Mr. Suder’s overall compensation to be QREs, electing instead to establish a new standard creating a reasonableness determination under section 174. The court reduced his overall reasonable salary accordingly (therefore at the end of the day allowing to be included in reasonable compensation for Mr. Suder $2.3 million for 2004; $2.4 million in 2005; $2.5 million in 2006 and $2.6 million in 2007 for purposes of calculating the QREs at 75%). In doing so, the court has made an already complex analysis yet more complicated (in other words, don’t try this at home boys and girls – the court even noted this is a very complex area of the tax code). The lesson: salaries of CEOs involved in research can be QREs – royalty payments to those CEOs will not qualify.

Despite this setback, this case was by and large an overwhelming victory for the taxpayer and points to the importance of having a qualified tax consultant when navigating such specialized areas of the tax code. By having a consultant establish a judicially approved method to claim the R&D tax credit, the taxpayer in this case received the best result possible. Make no mistake – those who try to claim this credit alone run a much higher risk of examination and a disallowance in credits.

The takeaway – the tax court in Suder sent a strong positive message to small businesses that the R&D tax credit is meant to cover a broad range of innovation and work encompassing both applied and basic science (and yes, even “routine research”) and reinventing the wheel is not required. Compensation of CEOs and other senior officials involved in R&D and product development can be included (or partially included) in QREs – but keep your feet on the ground. Good news indeed.

For more information about this case and what it means to U.S. taxpayers, please join alliantgroup for a complimentary CPE webinar tomorrow, October 22, 2014, regarding the ramifications of this ruling and the great opportunity it has provided for small and medium businesses.

For more information about R&D tax credits, contact BiggsKofford at info@biggskofford.com or call 719-579-9090.